Debt Fund of Funds: Mutual Funds Finding a Way to Offer Tax-Efficient Solutions

With respect to listed debt securities such as bonds, debentures, etc., the Long Term Capital Gain (LTCG) tax was increased to 12.5% from the previous 10%, with no indexation benefit available.

On the other hand, in the case of unlisted bonds, debentures, and debt mutual fund schemes, no change was made. The capital gains made on the redemption continued to be taxed at the marginal rate of taxation (i.e. as per one's income-tax slab), irrespective of whether LTCG or Short Term Capital Gain (STCG). Simply put, debt funds remained on par with bank fixed deposits for taxation (with changes made in the Finance Bill 2023).

Want to know how investments in mutual funds are currently taxed? Want this video:

[Read- Mutual Fund Taxation: Here Are the Key Changes After the Union Budget 2024-25]

But in the case of arbitrage funds, since they are mandated to invest a minimum of 65% of their total assets in equity & equity-related instruments by mainly following an arbitrage strategy (i.e. taking full-hedged equity positions to take advantage of the price difference between the spot and future markets) and balance 35% in debt and cash, the Long Term Capital Gains (for holding period of more than 12 months) were allowed to be taxed at the rate of 12.5% (without indexation benefit) for only the gains exceeding Rs 1.25 lakh in the financial year.

[Read: Should You Consider Arbitrage Funds After Change in Debt Mutual Fund Taxation]

Similarly, this tax treatment for arbitrage funds was allowed for Fund of Funds (FoFs), Multi Asset Allocation Funds and certain other types of mutual funds.

So, the disparity in the tax treatment was allowed to persist.

Mutual fund houses now, in the endeavour to offer tax-efficient investment solutions, are finding innovative and smart ways to deal with this capital gain tax anomaly.

HDFC Mutual Fund and Aditya Birla Sun Life Mutual Fund are seeking the capital market regulator's nod to launch HDFC Debt Advantage Fund of Funds and Aditya Birla Sun Life Income Optimiser Fund of Funds.

As per the draft Scheme Information Document (SID) filed with the capital market regulator, the HDFC Debt Advantage Fund of Funds has the mandate to invest predominantly in units of Arbitrage and Debt-oriented schemes. The Scheme will invest in the HDFC Arbitrage Fund or any other arbitrage fund as found suitable by the fund manager. Similarly, it will make investments in debt mutual fund schemes of HDFC Mutual Fund or debt schemes of other fund houses.

The Aditya Birla Sun Life Income Optimiser Fund of Funds has the mandate to invest in equity-oriented and debt-oriented schemes. The equity portion will be mainly invested in arbitrage funds (classified as equity for taxation), debt-oriented schemes (including debt ETFs), and the rest in debt & money market instruments and units of REITs & InVITs.

While the launch of these Schemes is subject to regulatory approval, going forward, many more fund houses would likely follow suit.

These funds of funds are expected to offer debt fund-like returns albeit with tax efficiency than pure debt funds. FoFs are unique investment propositions but, as an investor, you also ought to be mindful of the expense ratio charged.

What Should Be Your Investment Strategy to Invest in Debt Mutual Funds Now?

Well, it appears that the present interest rate upcycle has almost peaked.

As CPI inflation has moderated and the U.S. Federal Reserve also cut interest rates in the last Federal Open Market Committee (FOMC) meeting by 50 basis points (bps), it is likely that the six-member Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) may resolve to cut rates in the October 2024 bi-monthly monetary policy review meeting -- which is just ahead of Dussehra and Diwali -- by around 25 bps to support growth.

It would be an opportune time to invest in medium-to-long and longer-duration debt mutual funds with a view of 3 to 5 years, whereby you benefit from higher yield and unlock capital growth.

However, if you have a shorter investment horizon, consider investing in the shorter maturity debt funds, as they have a minimal mark-to-market impact when interest rates rise.

And say, if you have an investment horizon of up to or less than a year, it would be better to stick to the best Liquid Funds and/or Overnight Funds having no exposure to private issuers.

[Read: 3 Best Liquid Funds for 2024]

Always keep in mind that investing in debt funds, in general, is not risk-free. Hence, avoid investing in debt funds that engage in yield hunting to clock higher returns. Choose the safety of the principal over returns.

Broadly, whichever mutual fund scheme you invest in, make it a point to invest in congruence with the asset allocation best suited for you considering your age, risk profile, the broader investment objective, the envisioned financial goal/s you wish to address, and the time in hand to achieve those goals.

Be a thoughtful investor.

Happy Investing!

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Disclaimer: This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes. Use of this information is at the user's own risk. The user must make his own investment decisions based on his specific investment objective and financial position and use such independent advisors as he believes necessary.